Audit of the Payroll and Personnel Cycle Chapter 20

Learning Objective 1 Identify the accounts and transactions in the payroll and personnel cycle.

Accounts in the Payroll and Personnel Cycle The overall objective in the audit of the payroll and personnel cycle is to evaluate whether the account balances affected by the cycle are fairly stated in accordance with generally accepted accounting principles.

Accounts in the Payroll and Personnel Cycle Accrued Wages, Salaries, Bonuses, and Commissions Direct Labor Payment Beginning balance Cash in Bank Payment for salaries Earned wages, salaries, etc. Payment for payroll taxes Ending balance Withheld Income Taxes and Other Deductions Payment Beginning balance Payroll withholding Ending balance

Accounts in the Payroll and Personnel Cycle In most systems the accrued wages and salaries account is used only at the end of an accounting period.

Learning Objective 2 Describe the business functions and the related documents and records in the payroll and personnel cycle.

Business Functions in the Cycle and Related Documents and Records The payroll and personnel cycle…. Begins Personnel Hiring Ends Payments

Personnel and Employment Personnel records Deduction authorization form Rate authorization form Personnel records include such data as the date of employment, personnel investigations, rates of pay, authorized deductions, performance evaluations and termination of employment. This form is used to authorize payroll deductions including the number of exemptions for withholding income taxes. The rate form is used to authorize the rate of pay.

Timekeeping and Payroll Preparation Time Card Job Time Ticket Payroll Transaction File Payroll Journal Timekeeping and Payroll Preparation Adequate controls are necessary to prevent misstatements in the following activities: Prepare time records by employee Summarize and calculate gross pay Payment of payroll Prepare payroll records

Payroll Master File A payroll master file is used for recording each payroll transaction for each employee and maintaining total employee wages paid for the year to date. The payroll master file is a computer file used for recording payroll transactions for each employee and maintaining total employee wages paid for the year.

Payment of Payroll Payroll check Payroll bank account reconciliation Payments may be made by check but are usually deposited directly into an employee’s individual bank account.

Preparation of Payroll Tax Returns and Payment of Taxes W-2 Form Payroll tax returns The W-2 form is sent to each employee and summarizes the employee's earning for the calendar year. The payroll tax returns are forms submitted to local state and federal units of government to show payment of withheld taxes and the employer’s tax.

Learning Objective 3 Understand internal control and design and perform tests of controls and substantive tests of transactions for the payroll and personnel cycle.

Methodology for Designing Controls and Substantive Tests Understand internal control – payroll and personnel Assess planned control risk – payroll and personnel Determine extent of testing controls Design tests of controls and substantive tests of transactions for payroll and personnel to meet transaction-related audit objectives Internal control for payroll is normally highly structured and well-controlled to manage cash disbursed to minimize employee complaints and dissatisfaction to minimize payroll fraud. Tests of controls and substantive tests of transactions are the most important means of verifying account balances in the payroll and personnel cycle. These tests are emphasized because of the lack of independent third party evidence. Audit procedures Sample size Items to select Timing

Understand Internal Control –Payroll and Personnel Cycle Adequate separation of duties Proper authorization Adequate documents and records Physical control over assets and records Independent checks on performance Segregation of duties is necessary in the payroll cycle to prevent overpayments and payments to nonexistent employees. Only the human resources department should be authorized to add and delete employees from the payroll or change pay rates and deductions. The appropriate documents and records depend on the nature of the payroll system. Time records are necessary for hourly employees but not for salaried employees. Access to unsigned payroll checks should be restricted. Payroll computations should be independently verified including comparison of batch totals to summary reports.

Payroll Tax Forms and Payments Preparation of payroll tax forms Timely payment of the payroll taxes withheld and other withholdings As part of understanding internal control, the auditor should review the preparation of at least one of each type of payroll tax form that the client files.

Inventory and Fraudulent Payroll Considerations Relationship between payroll and inventory valuation Tests for nonexistent employees When labor is a material part of the inventory valuation, auditors should emphasize testing internal controls over proper classification of payroll transactions. Consistency from period to period is essential for classification.

Methodology for Designing Tests of Balances for Payroll Liabilities Identify client business risks affecting payroll liability accounts Phase I Set tolerable misstatement and assess inherent risk for payroll liability accounts Phase I Significant business risks affecting payroll are unlikely for most companies. However, risks may exist for complex compensation arrangements including bonus and stock option plans and other deferred compensation arrangements. Inherent risk is typically low for all balance related audit objectives. Assess control risk for the payroll and personnel cycle Phase I

Methodology for Designing Tests of Balances for Payroll Liabilities Design and perform tests of controls and substantive tests of transactions for the payroll and personnel cycle Phase II Tests of accrued payroll expenses are ordinarily straightforward if internal controls are operating effectively.

Methodology for Designing Tests of Balances for Payroll Liabilities Design and perform analytical procedures for the payroll and personnel cycle Phase III Design tests of details of payroll accounts balances to satisfy balance-related audit objectives Audit procedures Phase III Two major balance-related audit objectives in testing payroll liabilities are: 1. Accruals in the trial balance are stated at the correct amounts ( accuracy) 2. Transactions in the payroll and personnel cycle are recorded in the proper period. Sample size Items to select Timing

Learning Objective 4 Design and perform analytical procedures for the payroll and personnel cycle.

Analytical Procedures for the Payroll and Personnel Cycle Possible misstatement Compare payroll expense account balances with previous years Misstatement of payroll expense accounts Compare direct labor as a percentage of sales with previous years Misstatement of direct labor and inventory

Analytical Procedures for the Payroll and Personnel Cycle Possible misstatement Compare commission expense as a % of sales with previous years Misstatement of commission expense and commission liability Compare payroll tax expense as a % of salaries and wages with prior year Misstatement of payroll tax expense and payroll tax liability Compare accrued payroll tax accounts with prior year Misstatement of accrued payroll taxes and expense

Learning Objective 5 Design and perform tests of details of balances for accounts in the payroll and personnel cycle.

Two Major Balance-related Audit Objectives 1. Accruals in the trial balance are stated at the correct amounts (accuracy). 2. Transactions in the payroll and personnel cycle are recorded in the proper period (cutoff).

Tests of Details of Balances for Liability Accounts Amounts withheld from employees’ pay Accrued salaries and wages Accrued commissions Accrued bonuses Accrued vacation pay, sick pay, or other benefits Accrued payroll taxes Discuss how the auditor might test the above accrued payroll related accounts.

Tests of Details of Balances for Expense Accounts Officers’ compensation Commissions Payroll tax expense Total payroll Contract labor

Presentation and Disclosure Objectives Required disclosures are not extensive Some complex transactions require footnote disclosure

Types of Audit Tests for the Payroll and Personnel Cycle Cash in Bank Payroll Liabilities Direct Labor and Payroll Expenses Payments Expenses Audited by TOC, STOT, and AP Audited by TOC, STOT, and AP Ending balance Ending balance Audited by AP and TDB TOC + STOT + AP + TDB = Sufficient appropriate evidence per GAAS

End of Chapter 20